Markets & Finance

Oil's War Premium

April 02, 2002

By Tina Vital Sparked by the worsening crisis in the Middle East, the price of crude oil has shot higher over the past several days, though it did pull back slightly Apr. 3 on a surprise increase in inventories. Still, the May futures contract for the benchmark West Texas Intermediate (WTI) grade, at $27.56 per barrel, leaves crude hovering near its highest level since late September, 2001.

The sharp rise comes on fears of supply disruptions as violence in the Mideast escalates -- and amid calls from Iraq to impose a 1973-style oil-export embargo. Also helping to drive prices higher is better-than-expected compliance by OPEC members with the cartel's latest output ceilings and the prospect of rising demand, spurred by the U.S. economic recovery. The cartel's efforts to rein in production are starting to have an effect, as foreign oil inventories become tighter.

This trend should continue for the rest of the year. Standard & Poor's expects OPEC production to decline 4.5% in 2002, while output by non-OPEC members should rise by 1.9%. Furthermore, political unrest in Venezuela could dampen production there, exacerbating already slim supplies and pushing prices higher.

OPEC'S NEXT MOVE. As long as the conflict in the Middle East remains isolated, S&P doesn't see any major threat to world oil supplies. We view any Iraq-led effort to impose a new oil embargo as highly unlikely to succeed. We estimate that the current "war premium" built into oil prices is some $4 to $7 per barrel. And while any flare-ups in the region could lead to additional price spikes, such dramatic increases will also have the offsetting effect of moderating demand.

Overall, the trend remains upward for crude prices. Energy research outfit DRI-WEFA projects average WTI oil prices of $22.11 for 2002 and $23.32 for 2003. But a lot depends on what OPEC will do at its next meeting in Vienna on June 26. If WTI remain above $26 per barrel, then the cartel will likely raise production. Alternatively, if it drops back to the low-$20-per-barrel range, then it's less certain that OPEC will boost output. However, with world oil demand rising faster than expected, we're betting that OPEC hikes production by 1 million to 1.5 million barrels per day in June.

Where should investors be looking in the oil patch? S&P continues to rank integrated oil giant ExxonMobil (XOM) 5 STARS (buy). We like its huge, geographically diversified asset base, helping to make it a haven in the energy industry. With its steady earnings stream and conservative financial practices, ExxonMobil could provide investors a refuge from Enronitis.

CLIMBING DEMAND. Where else? We also have 5-STAR opinions on two contract drillers. Global Santa Fe (GSF) has attractive growth prospects and remains undervalued compared to its peers, while Nabors (NBR) is a play on rising natural-gas demand in North America and internationally.

And we like oil-field service provider Weatherford International (WFT). While worldwide long-term oil and natural-gas demand is expected to climb more than 2% annually, half of current production will have to be replaced. And with new oil and gas fields smaller to work -- and more expensive -- we expect producers to turn increasingly to Weatherford's cost-effective drilling technology, both in North America and overseas. Analyst Vital covers oil and gas stocks for Standard & Poor's